Liquidity is a short term risk. If you want to sell now, and nobody wants to buy, then you have liquidity risk. You have to lower the price until it’s attractive enough for someone else to buy it.
The issue with ETFs, index funds, and even actively managed funds, is the false impression that these funds are highly liquid when in fact they are only as liquid as the underlying assets. A high yield bond fund has the same liquidity risk as the bonds it holds. A microcap fund has the same liquidity risk as the microcap stocks it owns.
When a lot of people want to sell something – like fund managers due to redemptions – the price of the asset can fall drastically. When the underlying asset falls in price, the fund’s share price falls with it. And that can create a domino effect as other investors join in the stampede for the door.
But, as Howard Marks points out, liquidity is not a long-term risk:
You omit the possibility that somebody wants to be a long term investor, which is the only intelligent thing to be. Nobody knows what is going to happen in the markets tomorrow or next year. I watched the piece on Walmart. It’s down 4%. Is it a good buy or not a good buy? Where is it gonna close today? Is it gonna close down more or less than 4%? And the answer is none of us knows. Why should anybody act as if they knew. The only intelligent form of investing is long term investing, which means that if the markets going to turn illiquid, there’s no reason to run to the door. You hold a portfolio of high yield bonds. You hold it and you collect the interest and you get paid at maturity. And what goes on in the market – whether it becomes illiquid, whether other people sell, whether it cascades down in price – doesn’t matter if you’ve made a fundamentally good investment decision. – Howard Marks via Bloomberg
If you’re doing things right, you should never be forced to sell.
The long-term investor – who understands that day to day prices don’t always reflect the value of a fundamentally sound asset – will profit over time. And they can take advantage of it because one person’s liquidity risk is the long-term investors opportunity.
- Are Asset Managers Vulnerable to Fire Sales? – Liberty Street
- Are Low Interest Rates Driven by the Fed or by Fear? – CFA Institute
- Mystery Of Vanishing Premiums – L. Swedroe
- The Evolution of Good Investing Ideas – M. Housel
- How Can Smart Beta Go Horribly Wrong – Research Affiliates
- The Case for Activist Investors – HBR
- Are We Doomed to Slow Growth? – NY Times
- Bear Markets Don’t Predict Recessions, But Liquidity Might – BloombergView
- Why Wall Street is Embracing the Blockchain – Wired
- George Washington the Whiskey Baron of Mount Vernon – NY Times
- How a Basket on Wheels Revolutionized Grocery Shopping – Priceonomics
- DJCO 2016 Annual Meeting (full audio) – C. Munger
- Get Your Taxes Done Early and Save with TurboTax (Offer)